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OCCASIONAL PAPER SERIES

NO 130 / OCTOBER 2011

by Geoff Kenny and Julian Morgan

SOME LESSONS

FROM THE FINANCIAL

CRISIS FOR THE

ECONOMIC ANALYSIS

OCCASIONAL PAPER SERIES

NO 130 / OCTOBER 2011

by Geoff Kenny and Julian MorganSOME LESSONS

FROM THE FINANCIAL

CRISIS FOR THE

ECONOMIC ANALYSIS

1

1 This paper has benefited from discussions with a large number of colleagues within the European Central Bank (ECB) and the Eurosystem.

We have received substantial contributions and input from ECB staff in DG-Economics, DG-Research and DG-Statistics, especially K. Christoffel,

M. Ciccarelli, G. De Bondt, S. Dees, F. Fornari, E. Hahn, K. Hubrich, M. Lenza, L. Maurin, A. Meyler, F. Skudelny and O. Tristani. We would

H. Pill and F. Smets for their comments. This paper has further benefited from the contributions of C. Marchini, F. Masera,

L. Kezbere and M. Santoianni. In addition, some very helpful comments were received from members of the

Monetary Policy Committee of the European System of Central Banks and its Working Group on Forecasting at the seminars on this topic held in 2010. Please note that the views expressed in this paper do not necessarily reflect those of the ECB. This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science

Research Network electronic library at http://ssrn.com/abstract_id=1791644.NOTE: This Occasional Paper should not be reported as representing

the views of the European Central Bank (ECB).

The views expressed are those of the authors

and do not necessarily reflect those of the ECB. In 2011 all ECBpublicationsfeature a motiftaken fromthe €100 banknote.

© European Central Bank, 2011

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ISSN 1607-1484 (print)

ISSN 1725-6534 (online)

3 ECB

Occasional Paper No 130

October 2011

CONTENTS

ABSTRACT 4

NON-TECHNICAL SUMMARY 5

1 INTRODUCTION 6

2 UNDERSTANDING THE KEY DRIVERS

OF THE CRISIS 8

3 HOW DID THE ECONOMIC ANALYSIS

FARE DURING THE CRISIS?

12

3.1 The near-term outlook 12

3.2 Medium-term projections 13

3.3 Analysis of uncertainty

and risks 15

3.4 Macroeconomic models 17

4 THE BENEFIT OF HINDSIGHT:

WHAT SHOULD WE HAVE PAID

MORE ATTENTION TO? 19

4.1 Financial factors 19

4.2 Non-linearities 20

4.3 Confi dence, expectations

and uncertainty 20

4.4 Judgement 22

4.5 International linkages 23

5 WHAT IS THE WAY FORWARD? 24

5.1 Extend existing tools

and develop new ones 24

5.2 Develop ways to better

handle complexity 24

5.3 Develop further the risk analysis 25

6 CONCLUSIONS 26

REFERENCES 27

CONTENTS

4 ECB

Occasional Paper No 130

October 2011

ABSTRACT

The economics profession in general, and

economic forecasters in particular, have faced some understandable criticism for their failure to predict the timing and severity of the recent economic crisis. In this paper, we offer some assessment of the performance of the Economic

Analysis conducted at the ECB both in the run up

to and since the onset of the crisis. Drawing on this assessment, we then offer some indications of how the analysis of economic developments could be improved looking forward. The key priorities identifi ed include the need to: i) extend existing tools and/or develop new tools to account for important feedback mechanisms, for instance, improved real-fi nancial linkages and non-linear dynamics; ii) develop ways to handle the complexity arising from the presence of multiple models and alternative economic paradigms; and iii) given the limitations of point forecasts, to further develop risk and scenario analysis around baseline projections.

KEY WORDS: EURO AREA, FINANCIAL

CRISIS, MACRO ECONOMIC FORECASTING

JEL CLASSIFICATION: E02, E30, E2, C53

5 ECB

Occasional Paper No 130

October 2011

NON-TECHNICAL

SUMMARYNON-TECHNICAL SUMMARY

This paper draws on the experiences during

the run up to, and since the onset of, the recent fi nancial crisis to offer some indications of how the analysis of economic developments could be improved. In the fi rst section, the paper recalls the key economic and fi nancial drivers of the crisis, highlighting the role of fi nancial shocks linked to the re-pricing of risk, asset prices and fi nancing costs. A number of important non-fi nancial elements are also emphasised, such as confi dence and uncertainty shocks and deepening international linkages.

In Section 2, the predictive failure of

macroeconomic tools and expert judgement widely shared by institutional and private forecasters alike (as refl ected in the macroeconomic projections in specifi c periods strongly impacted by the crisis) is documented for both short and medium-term horizons.

One of the main conclusions to be drawn from

the analysis here is that the errors made by forecasters largely relate to the size of the shocks impacting the economy. Nevertheless, economic tools and models as well as expert judgement also failed to identify the importance and strength of key transmission and amplifi cation channels, especially those linked to fi nancial markets and uncertainty.

Hence, the third section of our paper identifi es

a number of factors which, with the benefi t of hindsight, could have received more attention from those conducting economic analysis during the period of crisis. These include the leading indicator properties of various fi nancial variables, the prevalence of the non- linear dynamics often neglected in economic tools and the signalling aspect of confi dence and uncertainty indicators. In addition, there would appear to be a case for relying more on judgement than on the results of mechanical tools, particularly in the immediate aftermath of unprecedented events (such as the collapse of Lehman Brothers in September 2008). Lastly, in the fi nal section of the paper, we identify a possible way forward, particularly in respect of the main priorities for developing the economic analysis. The key priorities identifi ed include the need to: i) extend existing tools and/ or develop new tools to account for important aspects, for instance, improved real-fi nancial linkages and non-linear dynamics; ii) develop ways to handle the complexity arising from the presence of multiple models and alternative economic paradigms; and iii) given the limitations of point forecasts, to further develop risk and scenario analysis around baseline projections. 6 ECB

Occasional Paper No 130

October 2011

1 INTRODUCTION

Economists, both those inside and outside

policy institutions, pay considerable attention to analysing conjunctural economic developments.

This helps them to better understand the current

state of the economy and to make predictions about future developments. The analysis of economic developments forms a key element of the stability-oriented monetary policy strategy of the European Central Bank (ECB) aimed at achieving price stability. 1

More specifi cally,

the economic analysis provides a forward- looking perspective on the outlook for and risks to price stability over the short to medium-term and therefore complements, and can be cross- checked with, an analysis of monetary developments that is particularly suited to explaining the evolution of price developments in the medium to long run. 2

In this paper, we focus on the approaches

adopted for analysing the economic conjuncture and attempt to draw out some key lessons from the experiences made during the fi nancial crisis. Although we concentrate on the methods widely used in central banks and international organisations, the conclusions reached are also likely to be relevant for all those engaged in conjunctural analysis.

In contrast to monetary analysis, economic

analysis can be characterised as focusing largely on models that are based on an assessment of economic variables and, in particular, the interplay between demand and supply in goods and labour markets. In the context of the ECB, an important part of the insights emerging from the economic analysis is summarised in the regular macroeconomic projections of

Eurosystem and ECB staff which are published

each year in June and December and in March and September, respectively.

The economic analysis also incorporates

fi nancial information to the extent that it is relevant for this assessment. Needless to say, such information proved to be a key part of the economic analysis during the crisis, where there was a clear tendency for fi nancial shocks to have an impact on the "real" demand and supply for goods and services and also for additional feedback effects from developments in the real economy to the fi nancial sector.

Given the important challenges posed by the

fi nancial crisis to the economic analysis, it now seems timely to take a step back and try to assess what possible insight can be gleaned from the performance of the economic analysis during the run-up to and since the onset of the crisis, and to already offer some indications as to how it may be improved in the light of our recent experience.

The paper is structured as follows. In the fi rst

section, we recall the key economic and fi nancial drivers of the crisis, highlighting the role of fi nancial shocks linked to risk re-pricing, asset prices and fi nancing costs for both fi rms and households. In addition, a number of important non-fi nancial elements are also emphasised, such as confi dence and uncertainty shocks, inventory adjustment as well as more intensive international linkages generated via trade.

In Section 2, the poor performance of

macroeconomic tools and expert judgement, as refl ected in the macroeconomic projections of the crisis period, is documented for both short and medium-term horizons. More importantly, we note that the large deterioration in the accuracy of macroeconomic forecasts was This two-pillar approach has proved very successful, both as 1 a device for processing and introducing a large set of complex and diverse information and for structuring the presentation of the factors underpinning the monetary policy decisions of the Governing Council. In particular, the information extracted from the two pillars is regularly presented to the public at the press conference that immediately follows the meeting in which the Governing Council takes its monetary policy decision for the euro area. It is also subsequently explained in the Monthly Bulletin of the ECB. Given the possibility of differing and even confl icting messages emerging from the analysis based on these pillars, a careful cross-checking of monetary and economic developments ensures the robustness of the analysis behind monetary policy decisions. In a recent contribution, Papademos and Stark (2010) consider 2 the possible enhancement of the monetary analysis while drawing on the lessons learnt from the fi nancial crisis of 2007-10. For the rapidly expanding fi eld of fi nancial stability analysis, Trichet (2011) discusses the intellectual challenges ahead. 7 ECB

Occasional Paper No 130

October 2011

1 INTRODUCTION

widely shared by institutional and private sector forecasters alike, including the ECB and the

Eurosystem. One of the main conclusions to be

drawn from the analysis here is that the errors made by forecasters largely relate to the large size of the shocks impacting the economy.quotesdbs_dbs31.pdfusesText_37

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